Warren Buffett Bets on Real Estate: Should You Join Him?

Net-lease real estate investment trust Store Capital (NYSE: STOR) recently announced that Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), the conglomerate led by billionaire Warren Buffett, has made a considerable investment in the company.

Berkshire bought a 9.8% stake in Store Capital for $377 million through its subsidiary National Indemnity, making it the third-largest shareholder. Here's a rundown of Store Capital's business and why it may have caught Berkshire's eye.

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What does Store Capital do?

Store Capital is a REIT that specializes in net-lease real estate. The company currently owns 1,750 properties, most of which are leased to tenants in the service and retail industries. Top tenants include AMC Theatres, Applebee's, and Camping World, just to name a few. The name STORE stands for single tenant operational real estate, and the company claims to be the leader in "profit-center net-lease" solutions.

"Net lease" real estate means that the tenants sign leases that require them to pay expenses such as property taxes, insurance, and building maintenance. These leases typically have long initial terms (10-plus years), and have rental increases built in.

Store Capital's average lease has a 1.8% annual rent escalation rate, and has 14 years remaining until expiration. At the end of the first quarter of 2017, 99.5% of the company's properties were occupied. In a nutshell, the net-lease structure results in steady, growing income for long time periods, minimizes vacancies, and eliminates most variable costs of property ownership.

Reasons Berkshire might like Store Capital

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To be clear, we don't know exactly why Berkshire Hathaway decided to invest in Store Capital. We also don't know if the investment was initiated by Buffett himself, one of his stock pickers, or someone else at Berkshire.

One unique aspect of Store's business model is that most of its leases require the tenants to deliver property-level financial statements, allowing the company to monitor the performance of each individual property and take appropriate steps to lower any perceived risks.

Store Capital also sees tremendous room to grow in the years ahead. The company estimates its investable real estate market at about $2.6 trillion in size, and believes that its customer-centered approach to property management and development capabilities gives it a competitive advantage.

Since inception, Store Capital has added 76 new properties to its portfolio in the average quarter, and repeat customers make up a third of new business, a good indicator of tenant satisfaction. With investment-grade credit and a $500 million credit facility, the company should have no problem pursuing additional opportunities as they arise.

Finally, from a value-investing standpoint, Store Capital looks like a compelling choice. Before the "Buffett rally," the stock had fallen by more than 25% over the past year, and the company's exposure to retail was likely a big factor. In other words, thanks to the market's perception that all brick-and-mortar retail is dying, Store Capital is trading for a discount even though there's no reason to believe it's in any trouble.

The company pays a 5.6% dividend yield that is not only safe, but has plenty of room to grow. In fact, Store Capital had a payout ratio of just 68% in 2016 (very low for a REIT) despite 8% and 7.4% dividend increases in 2015 and 2016, respectively.

Are retail fears overblown, and should Store Capital investors worry about the industry?

My answer to both parts of this question is "not really." There are some legitimate fears regarding the retail industry. For example, department stores and apparel retailers, as a whole, are not doing well at all. However, not all brick-and-mortar retailers are suffering, and Store Capital invests in the right kind of retail.

As Store Capital said in its latest investor presentation, its first step toward managing its risk is to "align with fundamental broad-based industries with likelihood of sustained relevance." This is a Warren Buffett-like statement if I've ever heard one.

Basically, the company is saying that instead of investing in properties occupied by just any retail tenant, it focuses on areas of retail that should stand the test of time. For example, service-based tenants such as restaurants are virtually immune to the e-commerce competition that is plaguing many retailers. Early child education centers, another of Store Capital's major property types, is another business that isn't going anywhere.

In all, two-thirds of Store Capital's portfolio is composed of service-based businesses. Another 15% is occupied by manufacturing tenants. Just 18% is brick-and-mortar retail, and much of these retailers operate in internet-resistant businesses such as furniture stores and sporting goods stores.

Should you invest in Store Capital with Buffett?

I never advise anyone to invest in a stock simply because a billionaire (or a billionaire's company) did. It's important to do your own research and decide whether or not the stock is appropriate for your particular goals and risk tolerance.

Having said that, there's a strong case to be made for investing in net-lease real estate, given the depressed valuations of REITs that own these types of properties. Store Capital looks like a compelling value with several competitive advantages and lots of room to grow, which could be why Berkshire decided to invest.

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